Wednesday, 2 September 2009

Countries experiencing rapid economic growth like China, India and Russia should be a good place to get higher stock market returns than stolid slower-growing places like Europe, right? Oops, not so fast.

Apparently, it ain't so. There is no relationship between a country's high GDP growth and stock market returns, especially not in the long run and only weakly in the short run. In Economic Growth and Equity Returns from SSRN, professor Jay Ritter calculated that there was in fact a negative relationship between economic growth and stock returns in 16 major countries (including Canada and the USA) over the period 1900 to 2002 - this chart is taken from the paper.

Other people have found the same thing, focusing on the USA - Crestmont Research's It's Not the Economy has a decade by decade chart showing the unpredictable differences in the same or opposite directions. CXO Advisory in Update: GDP Growth and Stock Market Returns tried calculating leads and lags to see GDP predicted the US market or vice versa and found that didn't really explain much either. In Canada, CIBC's Economic Insights of August 25th has this scatter plot which again demonstrates the same point.Ritter's explanation is that consumers and company managers get the benefit of GDP growth, not stockholders.

He also makes the dramatic statement that past stock returns are of no use in predicting future returns!

The main metric that does predict future returns according to Ritter is the smoothed earnings yield (taking a 10 year average of earnings to eliminate business cycle effects) i.e. Earnings / Price. "A low smoothed earnings yield does, however, predict low real stock price growth over the following ten years. In other words, P/E ratios revert towards the mean through price changes rather than earnings changes." The only caveats that could derail that relationship would be: if managers and employees take the profits due to shareholders (are shareholder rights well protected?) and; if some catastrophe like war, revolution, hyperinflation destroys the value of financial assets. Based on the numbers in 2004, Ritter said that real annual compounded stock returns would average 4.5% instead of the historical 7%. Crestmont's little blurb attached to their chart also says it's the P/E that matters.

Wish I had the data to do the calculation for today's markets. The Price part of the equation is down quite a bit, such that the E/P will be lower but is it enough to produce good future equity returns?

In any case, these studies suggest strongly that the assumption that China's rising economic success means assured investing success is wrong and likely to disappoint.